Alerts and Updates

Second Circuit Says License Agreement No-Challenge Clauses are Unenforceable When Entered into Before Litigation

July 19, 2012

It remains unclear whether certain contractual provisions intended to discourage a licensee from bringing an invalidity action would similarly be considered unenforceable.

On July 10, 2012, the United States Court of Appeals for the Second Circuit held in Rates Technology Inc. v. Speakeasy, Inc. that covenants prohibiting challenges to a patent's validity, along with liquidated damages provisions, are unenforceable where the covenants were entered into prior to litigation. This result is the same regardless of whether the agreements containing such covenants are styled as settlement agreements, license agreements or covenants not to sue.1

While it is clear that the Second Circuit considers no-challenge clauses and accompanying liquidated damages provisions to be unenforceable when entered into before litigation, it remains unclear whether certain contractual provisions intended to discourage a licensee from bringing an invalidity action would similarly be considered unenforceable.

Background of Case

In 2007, Rates Technology Inc. entered into a Covenant Not to Sue agreement with Speakeasy, Inc. Under the agreement, Rates agreed not to sue Speakeasy for any past or future infringement of two patents owned by Rates, and Speakeasy agreed to make a one-time payment of $475,000 to Rates. In addition, Speakeasy agreed not to challenge or assist others in challenging the validity of any claims under the patents covered by the agreement, and if it violated this no-challenge agreement, it would pay Rates liquidated damages in the amount of $12 million.

In 2010, Rates brought a lawsuit against Speakeasy and affiliated entities, including Best Buy Co., Inc., on the grounds that Speakeasy violated the no-challenge covenant in the Covenant Not to Sue agreement by assisting an affiliated entity to bring an action against Rates seeking a declaration that the two patents are invalid and unenforceable. The declaratory judgment action was subsequently voluntarily dismissed.

Legal Discussion

In Lear, Inc. v. Adkins, the United States Supreme Court previously ruled that patent licensees should be free to challenge the validity of the licensed patents and not be required to continue to pay royalties while challenging patent validity in the courts. The Supreme Court reasoned that the public interest in discovering invalid patents outweighs competing interests, including contract law principles supporting the enforceability of contracts.2

The Second Circuit in the Rates case found it helpful to distinguish several methods by which patent disputes regarding infringement and invalidity can be resolved:

A case can be litigated to a final court decision, which would normally trigger the doctrine of res judicata prohibiting a party from re-litigating issues that were raised or could have been raised in the action. In such a case, a licensee would not be permitted to re-challenge a patent after it was already held to be valid and enforceable in a final decision.

A dispute can be resolved through entry of a consent decree following litigation between the parties. The court recalled prior cases in which it and other circuit courts applying Lear decided that such consent decrees prevent future challenges to a patent's validity because principles of res judicata outweigh the public policy of rooting out invalid patents.

A dispute can be settled by the parties after the initiation of litigation but without a consent decree. The court recalled that it had previously held in Warner-Jenkinson Co. v. Allied Chemical Corp., that such a settlement did not prevent a patent licensee from subsequently challenging the validity of the patents. In Warner-Jenkinson, the court noted the result may have been different had there been a no-challenge clause in the agreement, but neither that court nor the Rates court needed to address the situation further.3

A dispute can be resolved by agreement before the initiation of litigation between the parties. This is the situation in the Rates case.

In this fourth situation, the Rates court indicated that a pre-litigation licensee does not have the opportunity to conduct discovery on validity issues. Therefore, the licensee does not have a full opportunity to assess validity before deciding whether to enter into the license agreement. Because licensees are the individuals with sufficient economic interests to challenge the patent's validity, the court decided that the public interest in discovering invalid patents would be significantly undermined if no-challenge clauses were enforced in the pre-litigation license context. As a result, the court held the Rates no-challenge clause, as well as the $12 million liquidated damages clause, are unenforceable.

License Agreement Practice Notes

The Rates decision means that at least in the Second Circuit (and the Ninth Circuit4), a contractual bar on a pre-litigation licensee (or recipient of a covenant not to sue) from challenging the validity of the underlying patent will not be enforceable, nor will a corresponding liquidated damages provision.

In the wake of the U.S. Supreme Court decision MedImmune, Inc. v. Genentech, Inc., which held that a patent licensee does not have to repudiate the license in order to challenge the validity of the licensed patent5, a number of commentators have suggested that licensors include provisions to discourage licensees from bringing invalidity actions, such as:

Termination rights for the licensor in the event the licensee challenges the underlying patent;

Increased royalties if the licensee challenges the patent (or alternatively, if the licensee challenges the patent and does not prevail); or

Payment of the licensor's attorneys' fees if the challenge is unsuccessful.

Whether these provisions are any more or less enforceable after the Rates decision is unclear. The Rates court struck down the $12 million liquidated damages clause along with the no-challenge clause. Would it similarly refuse to enforce a clause that does not prohibit a patent challenge, but instead provides for adverse consequences for the licensee if it does so? Presumably, this would depend on the level of a "chilling effect" the contractual provision would have on the licensee's right to bring an invalidity action, balanced against any competing interests. Perhaps a provision with an enormous deterrent would be more likely to be held unenforceable than a provision with only a moderate deterrent.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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